A few weeks ago, we mentioned a rather unusual technological endeavor to create an online currency. We received a few queries about this subject, so decided to provide a more thorough description of what digital currency is, how this system works, why it's appealing and how it might fall short of user expectations.

To understand digital currency, one must first note that money in the digital age has moved from a largely anonymous system to one increasingly laden with tracking, control and regulatory overhead. Our cold hard cash is now shepherded through a series of regulated financial institutions like banks, credit unions and lenders. Bitcoin, created in 2009 by Satoshi Nakamoto, is a peer-to-peer digital currency system that endeavors to re-establish both privacy and autonomy by avoiding the banking and government middlemen. The goal is to allow individuals and merchants to generate and exchange modern money directly. Once the Bitcoin software has been downloaded, a user can store Bitcoins and exchange them directly with other users or merchants — without the currency being verified by a third party such as a bank or government. It uses a unique system to prevent multiple-spending of each coin, which makes it an interesting development in the movement toward digital cash systems.

The model proposed by Bitcoin is in many ways a response to some of the privacy and autonomy concerns surrounding our current financial system. Current money systems now increasingly come with monitoring of financial transactions and blocking of financial anonymity. A peer-to-peer currency could theoretically offer an alternative to the bank practices that increasingly include sharing information on their customers who don't actively opt-out, and who may even then be able to share data with affiliates and joint marketers. Bitcoin is particularly interesting in the wake of recent events that demonstrated how financial institutions can make political decisions in whom they service, showcased by the decisions of PayPal, Visa, Mastercard and Bank of America to cut off services to Wikileaks. Bitcoin, if it were to live up to the dreams of its creators, might offer the kind of anonymity and freedom in the digital environment we associate with cash used in the offline world.

But Bitcoin's current implementation won't resolve all of the issues surrounding autonomy and privacy. Notably, the anonymity on Bitcoin is not entirely secure at this time, which makes its merits as a more private form of currency tenuous at best. There are also other weaknesses to the system, some significant, which should be understood before using Bitcoin. And as of this writing, Bitcoin can't be used to donate to Wikileaks. But even more important than these concerns is the fact that governments around the world may raise legal issues with any digital cash scheme — ranging from money laundering to tax evasion to a range of other regulatory concerns. Nonetheless, Bitcoin is an intriguing project and worth watching to see how it develops in the coming years.

While Bitcoin is relatively young, digital currencies have been around a long time. Digicash, released in 1994, is considered a pioneer of electronic cash using cryptography to maintain anonymity. The Ripple currency project relies on interpersonal relationships to allow communities to create their own money systems (which is similar to the Local Exchange Trading System). There is also the anonymous digital cash system eCache, which can only be accessed via the anonymous onion routing network Tor. There are also numerous other digital money projects that have been proposed over the years; Bitcoin is just the newest chapter in the ongoing effort to create wholly digital currency.

Bitcoin is not challenging to use. Anyone can go online and start generating Bitcoins. The computer creates a coin by dedicating CPU power to solving a mathematical problem; every time the problem is solved, a Bitcoin is generated and another problem is offered up. The total number of Bitcoins will approach 21,000,000 over time. Learn more.

Perhaps the most interesting dimension of the Bitcoin project is its unorthodox approach to fraud prevention. Traditional currency systems have relied on trusted third parties to verify that the same unit of currency is not exchanged multiple times. For example, when you make a purchase with your credit card, the credit card company adjusts your available balance. Bitcoin addresses this problem without a third party by making all transactions public. As Bitcoin developer Gavin Andresen explained, every coin has a digital signature attached to it for every transaction that takes place; each time the coin is exchanged, another signature is added. If two coins appear identical, the one that was accepted by the Bitcoin network first is considered valid. Even though the transactions are public, the individuals tied to the transactions are anonymous. This is similar to how the stock exchange makes stock values public without disclosing individual owners. See the technical paper: Bitcoin: a Peer-to-Peer Electronic Cash System.

It's too early to say whether Bitcoin will be a success. Any new currency system faces an uphill battle, both technically and legally. The worth of Bitcoins, if the system ever gets wide adoption, will be based on an ever-fluctuating market value. Merchants will need to accept Bitcoins as a placeholder for goods and services, just like any other form of currency. This has been a barrier to other digital cash options historically, so it's difficult to know whether Bitcoin will be better prepared to face these challenges. But many believe that there's a need for decentralized currency system, and Bitcoin certainly is a step toward censorship-resistant digital currency. Bitcoins can already be used to make purchases and can even be donated to a few of your favorite charities — including EFF.

3 comments:

AS I understand what you meant by digital currency is that its a virtual currency that can be traded in and if needed can also be exchanged to physical cash.Isn't it? Is it on same lines as Paypal operates

For purposes of this discussion, digital (or virtual) currency refers to an electronic currency that is privately-issued and the unit is non-political in nature. Therefore, the current Paypal would not qualify as a digital currency because it is merely a proxy account for the USD and other national currencies.

Follow The Monetary Future

Read the Monetary Future

Search the Monetary Future

About Me

I am an e-Money researcher and a Founding Director of the Bitcoin Foundation. My career has included senior influential posts at Sumitomo Bank, VISA, VeriSign, and Hushmail.

"Free-market protagonists, such as Matonis, regard cybercash as better than traditional government-issued or -regulated money, because it is determined by market forces and thus nonpolitical in nature." --Robert Guttmann, Professor of Economics at Hofstra University, in Cybercash: The Coming Era of Electronic Money, 2003

"Matonis is quite correct that the new technology makes easier the use of multiple private currencies." --Mark Bernkopf, Federal Reserve Bank of New York, in "Electronic Cash and Monetary Policy", 1996

"Matonis argues that what is about to happen in the world of money is nothing less than the birth of a new Knowledge Age industry: the development, issuance, and management of private currencies." --Seth Godin in Presenting Digital Cash, 1995